Capital One 2011 Annual Report Download - page 140

Interest rate risk also results from changes in customer behavior and competitors’ responses to changes in interest
rates or other market conditions. For example, decreases in mortgage rates generally result in faster than expected
prepayments, which may adversely affect earnings. Increases in interest rates, coupled with strong demand from
competitors for deposits, may influence industry pricing. Such competition may affect customer decisions to
maintain balances in the deposit accounts, which may require replacing lower cost deposits with higher cost
alternative sources of funding.
Foreign Exchange Risk
Foreign exchange risk represents exposure to changes in the values of current holdings and future cash flows
denominated in other currencies. The types of instruments exposed to this risk include investments in foreign
subsidiaries, foreign currency-denominated loans and securities, future cash flows in foreign currencies arising
from foreign exchange transactions, foreign currency-denominated debt and various foreign exchange derivative
instruments whose values fluctuate with changes in the level or volatility of currency exchange rates or foreign
interest rates.
We are exposed to changes in foreign exchange rates, which may impact the earnings of our foreign operations.
Our asset/liability management policy requires that we use derivatives to hedge material foreign currency
denominated transactions to limit our earnings exposure to foreign exchange risk. The estimated reduction in our
12-month earnings due to adverse foreign exchange rate movements corresponding to a 95% probability was less
than 2% as of December 31, 2011 and 2010. The precision of this estimate is limited due to the inherent
uncertainty of the underlying forecast assumptions.
Market Risk Management
We employ several techniques to manage our interest rate and foreign currency risk, which include, but are not
limited to, changing the maturity and re-pricing characteristics of our various assets and liabilities. Derivatives
are one of the primary tools we use in managing interest rate and foreign exchange risk. We execute our
derivative contracts in both over-the-counter and exchange-traded derivative markets. Although the majority of
our derivatives are interest rate swaps, we also use a variety of other derivative instruments, including caps,
floors, options, futures and forward contracts, to manage our interest rate and foreign currency risk. The
outstanding notional amount of our derivative contracts totaled $73.2 billion as of December 31, 2011, compared
with $50.7 billion as of December 31, 2010. This increase was primarily attributable to actions we took to
manage the anticipated impact of the ING Direct acquisition on our market risk exposure and regulatory capital
requirements.
From the date we entered into the agreement to acquire ING Direct to early August 2011, interest rates declined
substantially, which resulted in an increase in the estimated fair value of the ING Direct net assets and liabilities.
In order to capture some of the anticipated benefits to regulatory capital on the closing date attributable to this
decline in interest rates, in early August 2011, we entered into various interest-rate swap transactions with a total
notional principal amount of approximately $23.8 billion. We subsequently rebalanced the hedge in October
2011 adding an additional $1 billion in notional principal for a total combined notional principal amount of
approximately $24.8 billion. These combined swap transactions were intended to mitigate the effect of a rise in
interest rates on the fair values of a significant portion of the ING Direct assets and liabilities during the period
from when we entered into the swap transactions to the anticipated closing date of the ING Direct acquisition in
early 2012. Although the interest-rate swaps represented economic hedges, they were not designated for hedge
accounting under U.S. GAAP. Therefore, we recorded changes in the fair value of these interest-rate swaps in
earnings. In 2011, we recorded a mark-to-market loss of $277 million related to these interest-rate swaps, which
was attributable to the decline in interest rates. In conjunction with the acquisition of ING Direct on February 17,
2012, we terminated the $24.8 billion in interest-rate swaps related to the acquisition. At termination, the fair
value of the swaps was a net loss of $355 million. Based on current estimates, we believe the interest-rate swaps
related to the acquisition were effective in meeting our hedging objective. See “Note 11—Derivative Instruments
and Hedging Activities” for additional information.
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